di Barry Eichengreen
da Project Syindicate
Sentiment in European financial markets has turned. For the moment, the possibility of a Greek exit from the eurozone is off the table. If interest-rate spreads on Spanish and Italian government bonds are any guide, bondholders are no longer betting on a eurozone breakup. European stocks even rose in the week following last month’s inconclusive Italian elections.Investors evidently believe that Europe’s leaders will do just enough to hold their monetary union together. But, at the same time, it is unlikely that Europe’s economy will follow the pattern of emerging-market crises and rise, phoenix-like, from the ashes. Rather, the most likely scenario appears to be a Japanese-style lost decade of slow or no growth.
The first obstacle to a “phoenix miracle” is that governments remain in austerity mode. Yes, there are whispers that the pace of fiscal consolidation could be slowed; indeed, France has already been given more time to hit its deficit target. But this looks a lot like Japan, where the fiscal tap was tentatively opened and closed. Japanese consumers knew that increases in public spending were temporary, so they did not change their spending habits, rendering the policy ineffectual.
The European Central Bank, for its part, is reluctant to do anything to jump-start growth. Like the Bank of Japan in the 1990’s, it interprets its mandate narrowly. It remains a noncombatant in the global currency wars. But, with the BOJ joining the US Federal Reserve and the Bank of England in easing monetary policy, there will be upward pressure on the euro. And a strong euro is the last thing that a weak Europe needs.
Tepid US and global growth forecasts are reinforcing these fears. The few countries that have succeeded in growing, despite austerity, have done so by exporting. But, with global growth below trend in 2013, emulating them will be difficult. Likewise, the early-1990’s recession in the US depressed Japan’s exports and helped to initiate its lost decade.
Finally, Europe’s property-market and banking problems heighten the danger of a Japanese scenario. Japan’s banks invested heavily in commercial real estate and were dragged down when the property-market boom of the 1980’s went bust. Spanish banks are similarly exposed to the property sector and have not yet acknowledged their losses, while Europe, much like Japan 20 years ago, has done too little to strengthen its financial system.
Thus, in Europe now, as in Japan then, the pieces are in place for a lost decade: weak banks make for weak government finances, which in turn make for weak growth and even weaker banks, with the absence of monetary and fiscal support leaving no escape from this vicious spiral.
But there is one important difference. Even at its worst, unemployment in Japan rarely exceeded 4%, owing to a combination of early retirement, social programs, work-sharing, and political pressure on large employers. In the eurozone, by contrast, unemployment is running at a socially catastrophic 12% and is continuing to rise. In Spain and Greece, unemployment is approaching 30%, while youth unemployment is nearing a staggering 60%.
This makes the risk of social upheaval in Europe today much greater than it was in Japan two decades ago. We cannot predict when or where, but sooner or later there will be an explosion of protest, whether violent or taking the form of organized support for political parties espousing radically different policies. Either way, Plan A, in which governments do just enough to avert collapse but fail to jump-start growth, will no longer be viable.
The only question is whether disaffected voters will opt for a harmless comedian like Beppe Grillo or a more dangerous proto-fascist candidate to be named later. In the first case, the result will be economic chaos. There will be a falling out between the new populist government and German Chancellor Angela Merkel (and the ECB), creating high uncertainty about what comes next.
In the second case, the new government’s war of words and policies will be waged not just with the German government in Berlin and the ECB in Frankfurt, but also against minority and immigrant groups at home. The economic threat could be the least of Europe’s worries.
European leaders need to address these dangers. If they double down on status quo policies, their reign will eventually give way to an extended period of populist-inspired economic chaos and minority scapegoating. Alternatively, leaders can listen to their critics and adopt a balanced, two-handed approach that applies both supply-side reforms and supportive demand-side measures to the challenge of ending Europe’s malaise.
For better or worse, the fact that the most severe political and social turbulence is yet to come at least means that Europe will be unable to afford the dithering and half-measures that produced Japan’s lost decade. “If something cannot go on forever,” as the economist Herbert Stein famously put it, “it will stop.”